Strengthening Euro Area banks

Big changes are needed to strengthen the capital positions of euro area banks

European banks remain at the heart of the euro area crisis. Despite actions to strengthen banks and build a banking union, confidence in the euro area banking system remains weak, and is likely to remain so until underlying concerns over low capitalisation of some banks are addressed.

Low bank capitalisation persists in many countries despite an EU requirement that banks reach in 2012 a ratio of a minimum 9% of the best quality “Core Tier-1” capital to risk-weighted assets, in excess of the current international requirements.

Why has this new benchmark not been sufficient to boost confidence? In part, this is because it is based on risk-weighting of assets that likely understates risks, due to reliance on banks’ own internal risk models and, for example, the zero risk-weight given to sovereign debt. The ratio of Core Tier-1 capital to unweighted assets of euro area banks currently falls well short of 5% in many cases. This standard has been identified as a benchmark for well-capitalised banks in a recent OECD paper and it is more demanding than the minimum Basel III leverage ratio that will apply from 2018.

Increasing the capacity of European banks to absorb losses, by increasing their capital relative to assets, needs to be addressed in the coming years. If the euro area’s largest banks were to move to a 5% standard, the current capital shortage is estimated at around EUR 400bn (4¼ per cent of euro area GDP). This is not just a problem for banks in the “periphery” – there could be large capital needs in the major euro area countries. Future capital needs could be lessened if banks were required to separate commercial banking and market activities, reducing the total assets of the banking business.

Moving towards a stronger banking system would help to rebuild confidence and get credit flowing again.

Background on the estimates

This work covers selected OECD euro area countries only.

The estimates are based on company reports and OECD calculations for around 200 euro area banks using a bottom-up approach that, first, assesses the additional capital required for each individual bank to reach a 5% leverage ratio and then adds up capital needs for currently under-capitalised banks based on this yardstick to obtain national and area-wide estimates of additional capital needs. The estimates are based on consolidated bank balance sheets, which are prepared on an IFRS basis and refer to information available as of September 2012. The estimated increase in bank capital to reach the 5% leverage ratio in Greece is likely to decline substantially following the end-November decision of the Eurogroup to disburse the EFSF loan which includes 23.8 billion euros earmarked for bank recapitalisation. The estimates do not incorporate additional capital to cover potential future losses nor do they incorporate increases due to changes in the definition of Core Tier-1 capital under Basel III to be implemented by 2018.

It should be underlined that a 5% leverage ratio does not currently form part of the internationally agreed Basel III framework, which expresses capital requirements in terms of risk-weighted assets and Tier-1 rather than Core Tier-1 Capital. A 3% leverage ratio based on total assets has been proposed in that framework as a backstop from 2018.